Feb 27, 2010

Last decades, our perceptions of Financial Risk haven been constantly changing and - for sure - they will continue to do so in the future.

In the sixties and seventies of the 20th century 'risk' was mainly plain 'technical risk'. Risk Management was mainly used to support current strategies, as a defensive instrument.

More de-Tailed studies of risk in the nineties, created new instruments and models to manage (investment) risks. This led to the understanding that it was possible to take more risk because we could understand and manage it in a better way.

Next, at the beginning of the 21th century, these new risk models were expanded and transformed from passive to active instruments. New products and markets were developed by combining, cutting and mixing traditional asset products (stock, bonds, mortgages) with derivates. And just like in chemistry, where mixing innocent individual molecules could lead to an explosive new molecule, the asset markets got flooded with toxic, unknown risk-correlated products.

For most of us it became clear that it was not the risk ingredients (bonds, stocks, derivatives, etc) themselves that caused this turmoil, but our own (irresponsible) behavior, e.g. the way we ourselves were managing the asset products and models. Behavioral Finance was born.

After we poisoned the investment market landscape in the second half of this last decade, things turned for the worse. Instead of looking what we had done, where we were on the risk map and how we could clean up this mess, we kept on building debt and - except for sub prime mortgages - refused to restructure the market 0r to restrict the use of derivatives.No restrictions nor ethical guidelines on making money just from money (who pays for making money of money?).

Instead, with the latest development High Frequency Trading (1,000 orders per second ! ), covering about 60% of all U.S. equity trading and nearly half of U.S. futures trading, we finally lost our site on what is ethical or not.Main question is: Who has the guts and the power to stop this development?

Anyway, it's clear that our 'behavior' and a 'map of the risk landscape' are critical in understanding where we are heading with Risk......Let's start with behavioral finance

Behavioral FinanceOne of the world’s best experts in the field of behavioral finance is James Montier.His book Behavioural Finance is a classical must-read.

In a 2002 classic report titled 'Part Man, Part Monkey', Montier gives a number of common mental investment pitfalls. Here's a sum up of those pitfalls that might apply to actuaries just as well:

You know less than you think you do

Be less certain in your views, aim for timid forecasts and bold choices

Don't get hung up on one technique, tool, approach or view - flexibility and pragmatism are the order of the day

Listen to those who don't agree with you

You didn't know it all along, you just think you did

Forget relative valuation, forget market price, work out what the stock is worth (use reverse DCFs)

Don't take information at face value, think carefully about how it was presented to you

Trinity of RiskAccording to Montier the word 'Risk' is perhaps the most misunderstood concept in finance. In classical finance, risk is identified as the relative price volatility (beta). However that's not what risk really is about. 'Downside risk' (ie loss) is what really matters when it comes down to performance measurement. From an investment point of view, risk can be split up into three interrelated elements, the so called 'trinity of risk':

Business Risk (risk of business going broke)

Financial Risk (risk of using leverage)

Valuation risk (the margin of safety)

Valuation risk is the most tricky type of risk, as is explained in an excellent article 'The Biggest Mistakes in Valuation...' by Donald R. van Deventer from Kamakura Corporation. Here's the wrap up of the top 7 valuation mistakes in a humorous "daily life analogy"

The Fake Rolex Watch MistakeAsk the investment bank which sold you a fake Rolex what the Watch is worth

The Poker Game MistakeAsk someone else playing in the same game how you should bet

The War of the Worlds MistakeBelieve in a valuation technique Because everyone else thinks it's true

Speech Bernanke FED May 17, 2007“We believe the effect of the troubles in the subprime sector on the broader housing market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

Montier believes Bernanke missed the boat, had poor ideas on how to recover and on top of this, failed to learn from his mistakes. Montier guesses: There are none so blind as those who will not see!

Happy InvestorFor those of you who -after all this - don't succeed in becoming a happy investor, Montier has a simple advice on improving (plain) happiness. Here's the wrap up:

Don’t equate happiness with money.

Exercise regularly.

Devote time and effort to close relationships.

Pause for reflection, meditate on the good things in life.

Seek work that engages your skills, look to enjoy your job.

Give your body the sleep it needs.

Don’t pursue happiness for its own sake, enjoy the moment.

Take control of your life, set yourself achievable goals.

Map of RiskRisk is an interesting and never ending subject of discussion and development. Drawing a map of Risk, literally helps you to oversee the Risk battlefield. Draw your own map of risk in life to remember where you are, where you've been and where you'll be heading.....

Disclaimer

Maggid is an actuarial professional, and like every actuarial professional or human being, he makes mistakes. Maggid encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong.

Nothing written here, or in my writings at Actuary-Info is an invitation to undertake whatsoever action, in particular to buy or sell any particular security; at most, Maggid is handing out educated guesses as to what the markets may do. Maggid thinks that "The markets always find a new way to make a fool out of you", and so he encourages caution with every action, in particular in investing. Risk control wins the game in the long run, not bold moves.

Additionally, Maggid may occasionally write about accounting, actuarial, insurance, and tax or other specialized topics, but nothing written here or on Actuary-Info is meant to be a formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that Maggid can have no knowledge of.

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